Garzarelli: Still bullish after indicator declines

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NEW YORK (CBS.MW) -- Our 14-stock market indicator composite declined 6.30 points this month to 42.0 percent from 48.3 percent. The decline resulted from a strong rise in the number of bullish advisers -- a contrary indicator.

The four-week average rose to 69.5 percent, while the weekly level rose to 70.3 percent. This data is compiled by Investor?s Intelligence and is cautious for equity prices when more than 70 percent of advisers are bullish (over a four-week period).

Prior to the 1977 and 1984 declines in stock prices, 85 percent to 90 percent of investment advisers were bullish -- a record high. When this indicator is bearish and our overall stock market composite is above 30 percent, as is the case now, corrections of 4 percent to 7 percent are likely. A decline of about 4 percent already occurred from April 21st to April 27th.

Low probability

As of this writing, many market analysts are worrying about a Fed tightening and a large stock market correction. We believe the probability of a Fed tightening is low.

The last stepwise tightening occurred in 1994 when the Columbia Leading Inflation Index (CIBCR) was rising 6 percent to 8 percent, the index was upticking for five consecutive months prior to this tightening and during the 1997 hike, the CIBCR rose for four consecutive months.

Currently the CIBCR is falling -- off 2.9 percent -- and over the three months prior to March, the rate was -2.6 percent, -2.9 percent, and -1.0 percent. Although the money supply is high, some of the rise is due to temporary factors such as the flight of Asian investors into the dollar and the recent boom in mortgage refinancings.

We believe the Fed welcomes some weakness in the stock market because the recent 15 percent per quarter stock market gains are just too fast. A slower rising stock market is more satisfactory to Greenspan and Fed officials.

Economic factors

We took a look at the two prior Fed tightenings in 1994 and 1997 and compared economic conditions then to now. During the tightening 1994, the S&P 500 declined 8.3 percent, and in 1997, by 9.6 percent. Below we show some comparisons.

The S&P 500 EPS growth rate was at double digits in 1994 (22 percent), and in 1997, growth was 12 percent. Currently earnings are rising about 1 percent to 2 percent.

We believe Greenspan pays close attention to the CIBCR leading inflation index. Previously, at least four consecutive upticks in this index have led to the last two Fed tightenings. In comparison, as mentioned above, this index has declined recently for four consecutive months.

The change in industrial production is similar in all three periods. During the 1994 Fed tightening it was growing at 3.6 percent, and in 1997, by 5.0 percent. Currently it is rising 4.0 percent, however, the change in real retail sales is about 1 percemt lower now (at 1.7 percent) compared to 2.7 percent in both 1994 and 1997.

Over the last year, the deficit as a percentage of GDP has been declining significantly and currently it stands at a slight surplus. In 1994, the deficit was at 3.0 percent of GDP, and in 1997 it was still in deficit at about 1 percent of GDP. We continue to see a budget surplus through 2002.

Currently, the GDP deflator is about 1 percent lower than the rate prior to the last two tightenings. Moreover, we believe the deflator should remain at about 1.5 percent throughout the next four years.

During the Fed tightening in 1994, the 3-month bill rate rose by 50 basis points from November, 94, to February, 95, strangely however, the 10-year bond rate dropped by 50 basis points. We believe the reason for this unusual historical pattern was the perception of an improving Federal deficit and lower inflation helping to discount the positive implications of the tightening.

A Fed tightening now is highly unlikely but, should it happen, we see a similar situation; opposite movements in long and short rates occurring after an initial positive correlation.

What about Asia?

We believe the economy will slow because of the Asian crisis. There is still discussion among economists as to whether the Asian crisis will slow down the U.S. economy after all. We believe it will, although not immediately.

As the economic process continues, it takes about 6 to 12 months for the full effects of the Asian flu to slow the US economy via lower company earnings (affecting capital spending, then employment, and finally consumption).

As mentioned in previous reports, because of cyclical reasons, as well as the progression of the Asian crisis, we believe real GDP growth will slow to around 2.0 percent later this year. We predict an 80 percent drop for corporate earnings generated in Asia, and a slight gain for those generated from the other OECD countries. Asia represents about 6 percent of S&P 500 earnings, while OECD countries account for about 15 percent.

When solving the model, we assumed inflation as measured by the chain GDP deflator will average about 1.5 percent through the year 2000 -- currently it's running at about that rate year-over-year. If we assume 1.5% percent inflation, our model suggests a 10-year bond rate of 4.6 percent at equilibrium by 2000, should the budget stay near its current small surplus.

Assuming operating earnings remain flattish at 45.00 through the year 2000, with the bond yield at 4.6 percent, the S&P 500 should reach 1,400 by the year 2000 -- an approximate 11,400 Dow.

This year we forecast the 10-year bond yield will fall to around 5.4 percent. Oour model, however, is even more bullish at a 4.6% yield for this year. S&P 500 earnings will be flattish, and the S&P 500 will reach 1190 over the next 6 to 12 months -- an approximate 9700 Dow level.

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